The alternative title could be "How to identify changing conditions".The markets are displayed through numbers, but the numbers represent a language more than a factual value. Learning to “read, write and speak” this language is not mathematics, it's art. It's sort of like the English language: for every rule there are 10 exceptions! That's why every rule-based setup will fail every so often. One way to stay in tune with the “language of the markets” is to understand market dynamics. So let's dig right in.
1. The importance of Market Dynamics
Markets have always been – and will always be – driven by greed and fear. Hence, the way a market moves up (two steps forward, one step back) and down (taking the slide as opposed to stairs) will more or less remain unchanged. And yet some professionals that make money for a few years, tend to run into a brick wall. Some traders give up the ghost after 20 years of activity. And newcomers struggle to get their footing. Why is this?
Surely the markets are not something a rocket-scientist likes to cut his teeth on. By definition, people that like mathematics and smooth equations also like certainty. They like to create a solution for a problem. But even if the markets are driven by supply and demand, which in turn is driven by emerging fundamentals, mathematics will not tell you how to profit in the markets. Traditional trader training goes something like this “learn a high probability setup and execute it whenever you see it”. And yet the setup will work sometimes and not other times. What's worse is that 1 single setup may not be an “all-weather setup”. Why does the setup work some days and not other days? Why do some strategies reap huge returns some years, and suffer even larger drawdowns the next?
At least part of the answer lies in Market Dynamics. And with market dynamics we mean essentially 3 things:
- volatility
- drivers
- liquidity
2. Drivers
Even the great Technical Analyst, Martin Pring, had to admit “The more I work with markets, the more it becomes apparent that prices are determined by one thing and one thing only, and that is people's changing attitudes toward emerging fundamentals”. Fundamentals cause people to rethink their opinions and hence make decisions. It's fundamentals that move markets, just not in the way textbooks usually explain them.
We will speak about “emerging fundamentals” extensively in another post, so here we're only going to explore the usefulness of knowing what's driving the markets. Again, our main objective is to decipher the difference beteween “chart watching”, taking trades based only on price action setups, and following market dynamics – trying to stack the odds more firmly in our corner. Let's go with a good - yet not that recent - example.
YM vs. UsdJpy – Daily chart
Source: Tradingview.com
In the chart above, we can see the disconnect between YM and UsdJpy. Do they always have to move in lockstep? Absolutely not. It depends on what is driving the markets. However, the market at the time started to focus on the series of geopolitical tensions present. To list a few of them:
- Russian/Ukraine debate
- US air strike authorization in Iraq
- Gaza strip tensions
So in conditions like that, what makes more sense? That the UsdJpy and the other XXX/Jpy crosses continue to move higher – typically a risk-on trade – or correlate again with the YM and start to drift lower? Of course, if you were following what the market was concentrated on, you would have had very few doubts.
Source: FXCM Marketscope
The main objection to this analysis is “so I have to follow everything that's happening in the world and take note of it at all times? That's cumbersome and I'll never be able to trade if that's what is required”. The first impact with this type of analysis can seem overwhelming but it all comes down to an organized way of collecting and filtering information in a relevant sense.
3. Volatility
But identifying and playing in line with the relevant market drivers isn't all that's concerned with Market Dynamics. Volatility also has an important role, and an important correlation with profitability.
Currency Managers' CTA Index – Yearly Performance
Source: Barclayhedge
What had changed since 2013 to make 2014 a year of general losses compared to 2013? At least one reason comes from the dimished volatility. You see, volatility creates opportunity. Volatility also allows for profit, even the entry (market timing) is somewhat wrong. Volatility also increases the odds of profiting when timing and direction are right.
YM and the Average True Range on the Daily chart as a measure of volatility
Source: Tradingview.com
Now let's take a look at the volatility of the Euro (EurUsd), the most heavily traded currency, to see what had changed from 2013 to 2014.
EurUsd Volatility on the Daily Chart has been steadily decreasing since 2013.
Source: Tradingview.com
We can also understand more about the importance of volatility by studying less-informed traders' habits, as opposed to professional and more experienced traders. A study done by a well-known retail FX broker shows how retail traders tend to be range-traders: they buy low and sell high. This is a range-trading strategy. Surprizingly, retail traders tend to have more success during the Asian trading hours.
Source: Dailyfx.com
Now if, by definition, the common retail trader does not have long-term profitability and good habits then we should look to avoid their habits. In fact, trading during Asian hours generally there is low participation and low liquidity in the FX market and this is precisely why professionals rarely participate: the moves are shallow and the possibility of having “rogue moves” is much higher than during London and New York. The “secret” to the success of retail traders during the Asian hours is that they are benefitting from the low volatility environment and they are taking quick pips from the market. But as soon as London steps into gear, the professionals enter the room benefitting from the rise in volatility, and the retail traders start to lose their grip on things.
Notice how regular the volatility is in FX: it picks up during London, rises through New York and then calms down during Asia.
Source: Tradingview.com
So basically, professionals need volatility in order to reap profits from the market, while retail traders benefit from the opposite environment because – frankly – they do not have a good grip on Market Dynamics, market microstructure, patience and many other qualities necessary in order to make trading work.
4. Liquidity
We touched on the aspect of liquidity implicitly when we spoke about volatility. In FX, when London comes online, not only does volatility increase but liquidity also increases. More liquidity often does not mean more volatility – actually it's usually the opposite. When there is less participation is becomes easier to move the market and rogue moves can happen more easily. But when there is a reason for calling on more participants (like the opening of a major financial center like London or New York), or a reason that the whole market can see (for example the Lehman Brothers' bankruptcy) then increased volatility is a by-product of increased participation. More agendas enter the scene, plop their orders onto the market and away it goes.
An illustration of the general liquidity conditions of various assets
Source: traders.com
Why is liquidity important to us traders? Liquidity is important because we're not all Jesse Livermore. Back in the 1920s, he was able to move some commodity markets with his own buying power. He was able to uncover hidden speculative interest on his own depending on the market's reaction. We do not have that luxury. We need to identify the conditions that will most likely bring other players – bigger players – to the field and play in line with our expectations.
We need other people's liquidity. We need to step into the market when volatility is decent, drivers are clear, and liquidity (participation) is high, so that the chances of having a significant move are as high as we can get them to be. So when are bad times to participate, or enter trades?
- Sunday night/early monday morning
- Friday afternoons
- Overnight during the Asian markets (for FX)
- During the first 30 minutes or so after the open, on Equities and Indicies
- Immediately before/after big news announcements (like NFP or Central Bank meetings)
So it really does boil down to common sense.
To sum up: Market Dynamics are constantly changing and in order to stay in tune with the market, and not be caught by surprize, it's best to stay in tune with them. Understand what is driving the market. Understand what type of volatility conditions are present. And enter into positions with confidence when there is high participation.
Good Luck!
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